What Is Happening to M3?

September 18, 2006 – In November 2005 the Federal Reserve announced that it would no longer compile and publicly report M3, which is the total quantity of dollars in circulation. I strongly derided the Fed’s decision, commenting that it would have unfavorable consequences for the dollar.

My thinking was that the termination of M3 reporting would make people nervous. It stands to reason that confidence in a currency is built when there is full disclosure. The absence of disclosure inevitably results in the erosion of confidence in a currency’s prospects, which is only logical. How can one have confidence in a currency when we don’t know how much of it is being created?

I wrote in my article “Alan Greenspan’s Legacy” on November 14th, 2005 that “the Fed is shooting itself in the foot. This misstep will only hasten the rush out of dollars into the safety and security of gold.” That describes exactly what has happened. Gold and silver have risen 23.1% and 38.6% respectively since then. And despite the federal government’s concerted intervention in recent months aimed to keep the dollar from falling off the cliff, the US Dollar Index has dropped 6.7% during this same period.

Word is spreading. People are increasingly recognizing that the US dollar is in trouble, and rather than trying to fix any of its many problems, the feds instead are relying upon the force of their market interventions coupled with their usual propaganda that it favors a “strong US dollar”. It is very ironic indeed that Treasury Secretary Paulson utters a strong dollar policy out of one side of his mouth, while at the same time uttering from the other side that the Chinese need to substantially revalue their currency, which is just a different way of saying that he is in reality pursuing a weak US dollar policy.

Although we no longer have M3 available to see the damage the feds are doing by inflating the quantity of dollars, there is plenty of anecdotal evidence demonstrating that they are doing just that. This evidence provides quite reliable proof that M3 is being expanded at reckless rates of growth. To explain this proof, it is first necessary to provide some money creation basics. There is a lot of misunderstanding about how it happens – about how dollars are created.

Most people think banks first receive deposits, with which they then make loans. However, this approach ignores the question of how those deposits came into existence in the first place, which of course is by the bank making loans. So while we do not know whether the chicken or egg came first, with money it’s clear – bank loans are what create bank deposits. That’s all there is to it. That is the basic process explaining how US dollars are created, but we also need to look at bank accounting.

The accounting is simple. Loans are bank assets (borrowers owe dollars to the bank), and deposits are bank liabilities (the bank owes dollars to its depositors).

The dollars in bank deposits are used by bank customers as currency, for example, by writing a check on the dollars deposited in a checking account. The banking system’s liabilities are one type of currency, called ‘deposit currency’, but it is worthwhile to note that there are two types of dollar currency. The other type of dollar currency is of course the paper notes issued by the Federal Reserve (i.e., the green paper we carry in our pockets), but these can be ignored because their quantity is relatively small. Paper notes were only 7.1% of the total quantity of dollars in circulation when the Fed stopped reporting M3.

Having established these background basics, we can now turn to the above chart, which was prepared by Sanders Research Associates in England, www.sandersresearch.com. It presents the change in US corporate borrowing, with the important point being the big surge over the past year or so. Companies are rapidly increasing their debt, which is evidence that banks are increasing their loans (i.e., assets) and simultaneously increasing their deposit liabilities (i.e., M3 is soaring). Some further explanation is necessary though for precision.

Corporate borrowing includes commercial paper, which is a form of debt where dollars are borrowed from other companies and not banks. So while commercial paper increases total debt in the US, it does not increase the money supply. We can get a more precise picture of bank credit by looking at different reports provided by the Federal Reserve. These reports now take on increasing importance given that M3 is no longer being reported.

Please note the following growth rates in bank loans reported by Doug Noland in his weekly commentary at the Prudent Bear website: www.prudentbear.com

“Bank Credit expanded $7.0 billion last week to a record $8.060TN (8-wk gain of $115bn). Year-to-date, Bank Credit has expanded $553 billion, or 10.6% annualized. Bank Credit inflated $655 billion, or 9.5%, over 52 weeks…Commercial & Industrial (C&I) Loans have expanded at a 16.2% rate y-t-d and 14.7% over the past year. For the week, C&I loans gained $1.3 billion, and Real Estate loans increased $2.5 billion. Real Estate loans have expanded at a 10.5% rate y-t-d and were up 10.1% during the past 52 weeks.”

These are staggering rates of increase. Having established above the basics of money creation, it is now easy to understand what these growth rates mean.

Basically, these growth rates are a continuation of a long-term trend, now well established, to expand credit. Because bank liabilities increase when bank assets increase, this expansion of credit through new loans means that M3 is also rising at more or less the same rates of growth.

So even though M3 is no longer being reported, we have very good evidence to show what is happening to the total quantity of dollars. In short, the Fed has the ‘pedal to the metal’, in effect doing everything it can to pump up the money supply.

It is not too hard to envision what the Fed is thinking. The economy is heading into a slowdown, with key components like housing and automobile manufacturing leaning over the cliff and staring into the abyss. So it is clear why the Fed stopped reporting M3. As I wrote back in November 2005:

“Why does the Fed no longer want to report the total quantity of dollars in circulation?They know what’s coming – massive amounts of dollar creation to fund the worsening trade and federal government budget deficits.” [Emphasis in original]

The upshot of all this is that the dollar continues on the road to its inevitable destruction. The flipside of that coin is that both gold and silver are going to climb much, much higher in terms of dollars. Their rising prices reflect the dollar’s ongoing collapse.

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My objective is to share with you my views on gold, which in recent decades has become one of the world’s most misunderstood asset classes. This low level of knowledge about gold creates a wonderful opportunity and competitive edge to everyone who truly understands gold and money.